Tax Benefits in Multi-Family Real Estate Development Lower Effective Tax Rates

By Greg Fedorinchik, Managing Director, Equity Capital Markets

Comparing returns for taxable accounts on an “apples-to-apples” basis requires that investments be compared on an after-tax basis. Many real estate investments are inherently more tax efficient than other types of passive investments—and that is particularly so with respect to equity investments in real estate development projects or funds like those offered by NexMetro Communities. Below, the NexMetro Financial Planning and Analysis team estimates the effective tax rate for some of our recent project sales and discusses their tax efficiency relative to other types of growth investments.

What are the key characteristics that can help to improve tax efficiency and reduce an investment’s effective tax rate?
1.) Generating passive losses: Passive (non-cash) losses from operating expenses and depreciation in early years can be particularly beneficial from a tax perspective since those paper losses can offset other passive income in taxable portfolios and unused passive losses are carried forward to future years.
2.) Minimizing distributable net income: Income is generally taxed at the highest marginal tax rate (up to 37%) for high income earners. Therefore, investments that generate and distribute high levels of income are less tax efficient.
3.) Long-term capital gains vs short-term capital gains: Long-term capital gains (gains on investments held for more than one year) are typically subject to a lower, 20% federal tax rate, while short-term capital gains tend to be taxed like regular income.

What are the impacts of taxes and benefits of lowering the effective tax rate? Consider this example. If a $1M initial investment returned a simple 20% each year over a 5-year period it would effectively double to approximately $2M. That would be a 20% internal rate of return (IRR) a 2.0X multiple on invested capital (MOIC) and $1M in income and gains before taxes. If we assume the returns were comprised of equal amounts of income and realized gains, we might reasonably assume an all-in effective tax rate of 28% (blending capital gains and income), yielding an after-tax amount of $720,000. In this example, the after-tax IRR drops to 14.4% and the MOIC to 1.72X.

In this example, a reduction of the effective tax rate from 28% to15% would yield an after-tax amount of $850,000 for the investor – or $130,000 more in the investor’s pocket. The effective after-tax IRR would jump from up to 17% and the MOIC would rise from 1.72 to 1.85. Taxes matter. A lot. And, while this example uses a number of simplifying assumptions regarding the timing of cash flows, we believe it might actually be conservative in considering the benefits of investing in real estate development projects and funds vs. other types of investments.

NexMetro has analyzed results across our five most recently completed and exited projects to assess what the effective tax rate has been. We estimate the average effective tax rate on these recent project sales to be about 15.7% and believe this compares favorably to other growth investments that could have effective tax rates in the 25-30% range or higher. The results are summarized in the table below.

The average duration of investments in the table was a total holding period of 45 months with an average multiple of 2.6x. While we do not expect all projects to generate average net returns of 30%, even those very high performing projects in the above table have effective tax rates that are much lower than other types of growth investments. Driving this low effective tax rate are passive losses in early years that can be netted against passive income and gains in other parts of investors’ portfolios, and the fact that most of the gains on a sold project come in the form of long-term capital gains.

In comparison, growth-oriented investments like equity mutual funds, and even actively managed equity ETFs, tend to have much higher effective tax rates. That’s because even if an investor buys and holds one of these investments for many years, the funds themselves tend to have significant turnover. Average turnover rates for the largest equity mutual funds are estimated at 60% or more. Even when including a mix of passive equity funds, average turnover rates are estimated to be higher than 30% annually. That means both long-term gains (taxed at 20%) and short-term gains (taxed as regular income as high as 37%) are being realized each year; and those funds are generating dividend income (also typically taxed at 20% or more).

While every person’s tax circumstances are different, our initial example above could be very close to reality. Comparing investments in taxable accounts on an after-tax basis is critical. A before-tax return from a public market portfolio is very unlikely to have similar after tax returns as a tax-efficient real estate investment. We suggest you consult with a tax advisor when considering tax issues related to your investments, and highly recommend comparing potential investments on an after-tax basis.

*Note: The key assumptions in our analysis of effective tax rates assumes investors are in the top tax bracket and achieve maximum tax savings from netting losses and from marginal differences in income vs capital gains tax rates. We do not account for state taxes which can impact these results further.